The Economics of European Integration

The Economics of European Integration

Chapter 5 Essential Economics of Preferential Liberalisation

The PTA Diagram Studying European integrations e.g. EEC s customs union which were discriminatory, i.e. preferential requires: at least three countries: at least two integrating nations. at least one excluded nation. Ability to track domestic and international consequences of liberalisation. Must MD-MS diagram to allow for two sources of imports.

The PTA Diagram: Free trade eq m Domestic price XS R XS P MS 1 2 P FT MD X R X P M=X P +X R imports

The PTA Diagram: MFN tariff eq m Domestic price MS MFN XS R XS P MS P -T 1 2 T P FT P MD X R X R X P X P M M=X P +X R imports

Discriminatory, unilateral liberalization To build up to analysis of real-world policy changes (e.g. customs union): Consider removes T on imports only from. 1 st step is to construct the new MS curve. The liberalisation shifts up MS (as with MFN liberalisation) but not as far since only on half of imports. Shifts up MS to half way between MS (free trade) and MS (MFN T), but More complex, kinked MS curve with PTA.

Discriminatory, unilateral liberalization Domestic price MS MFN MS PTA XS R XS P MS P P P P -T P -T T P a p* T 1 MD X R X R X P X P M M imports

Domestic price & border price changes domestic price falls to P from P. -based firms see border price rise, P -T to P. firms see border price fall from P -T to P -T. XS R XS P Domestic price MS MFN MS PTA P -T P -T T P P -T P MS P MD X R X R X P X P M M imports

Quantity changes: supply switching exports fall. exports rise more than exports fall, so domestic imports rise. XS R XS P Domestic price MS MFN MS PTA P -T P -T T P P -T P MS P MD X R X R X P X P M M imports

Impact of customs union formation EEC-6 Other 6 Europe Rest of W orld $100 100% $90 80% 60% 40% 20% $ billion (current prices) $80 $70 $60 $50 $40 $30 $20 $10 EEC T otal imp ort s 0% $0 1970 1969 1968 1967 1966 1965 1964 1963 1962 1961 1960 1959 1958 1970 1969 1968 1967 1966 1965 1964 1963 1962 1961 1960 1959 1958 Note: Left panel shows share of EEC6 s import from the three regions. Other Euro-6 are the 6 countries that joined the EU by the mid 1980s, UK, Ireland, Denmark, Spain, Portugal and Greece. Source: Table 5, External Trade and Balance of Payments, Statistical Yearbook, Recapitulation, 1958-1991,

Welfare effects s net change = A+B-C. s net change = +D. s net change = -E. XS R XS P Domestic price A P -T P -T E P D P P P -T P -T C B MD X R X R X P X P X R M M imports

Analysis of a Customs Union European integration involved a sequence preferential liberalisations but all of these were reciprocal. In example, both & drop T on each other s exports. Need to address the 3-nation trade pattern. Good 3 Good 1 Good 1 Good 2 Good 2 Good 3

Analysis of a Customs Union FTA vs Customs Unions. Given symmetry 3-nation set up, FTA between and is automatically a customs union. - CU has Common External Tariff (CET) equal to T in the real world, things are more complicated. Analysis is simply a matter of recombining results from the unilateral preferential case. In market for good 1, analysis is identical. In market for good 2, plays the role of. In market for good 2, plays role of.

Welfare effects of a customs union In market for good 1: change = A+B-C 1 -C 2. In market for good 2: change = +D 1 +D 2. NB: D 1 =C 1. Net impact =A+B-C 2 +D 2. impact identical. loses. euros P P -T D 2 XS euros P D 1 C 2 C 1 P -T X P X P X R X P B M. The Economics of European Integration, 2 nd Edition A MD imports

Trade creation & diversion Trade creation & diversion is jargon that is often used. It is imprecise, but widely used. Intuition for why it is so popular, despite its shortcomings. It captures ambiguity of welfare gains in two words. Discriminatory liberalisation. Liberalisation = tends to improve welfare ~ trade creation Discrimination -= tends to diminish welfare ~ trade diversion

Not just tariffs

Frictional barrier preferential Liberalisation In market for good 1: change = A+F. In market for good 2: change = +D. Net impact: =A+F+D. Unambiguously positive. gains same. loses. euros P P -T euros XS P F D P -T X P X P X R X P M A MD imports

Customs Union vs FTA FTA like CU but no Common External Tariff. Opens door to tariff cheats, goods from destined for market enter via if has lower external tariff, called trade deflection. Solution is rules of origin meant to establish where a good was made. Problems: Difficult and expensive to administer, especially as world get more integrated. Rules often become vehicle for disguised protection. Despite the origin-problem in FTAs, almost all preferential trade arrangements in world are FTAs. CU s require some political integration. Must agree on CET and how to change it, including anti-dumping duties, etc.

WTO Rules A basic principle of the WTO/GATT is nondiscrimination in application of tariffs. FTAs and CUs violate this principle. Article 24 permits FTAs and CUs subject to conditions: Substantially all trade must be covered. Cannot pick and choose products. Intra-bloc tariffs must go to zero within reasonable period. If CU, the CET must not on average be higher than the external tariffs of the CU members were before. In EEC s CU this meant France and Italy lowered their tariffs, Benelux nations raised theirs (German tariffs were about at the average anyway).

Kemp Wan Theorem Possible to alter CET to get Pareto improvement. Form CU and adjust CET to ensure zero external trade effect (thus welfare impact on is zero). Treat external trade vector as part of endowment vector & First Welfare Theorem tells us FT between partners achieves FB and so is better than distorted equilibrium. Not practical, but an intellectual landmark (FTAs need not be bad).